Bank should step back and allow rise in exchange rate

THE Central Bank faces a crucial test. The choices it makes over the coming months could go a long way to deciding whether or not we qualify for the single currency.

Over the past couple of years the bank has made an excellent job of running a booming economy while controlling inflation. But the gods have been on its side. It is now facing what could be its most difficult period since the currency crisis.

Since that time, sterling has been generally weak on international markets and the deutschmark strong. This has allowed the pound to trade well above parity with sterling, dampening inflation, while keeping within a tight range of the D mark.

But that has now changed. Sterling is the strong currency of Europe. And the weakening of the pound against sterling may again have the bank worrying about its old nemesis - inflation.

Meeting the inflation target for qualification for the single currency - next year's rate is the one which will count - is not guaranteed. The key inflation figure for Maastricht qualification is the EU harmonised index and Ireland's rate must be no more than 1.5 percentage points above the average of the lowest three in the EU. On this measure, our inflation rate is only within the criteria by a small margin.

On a crude rule of thumb a 1 per cent fall in the value of the pound against sterling pushes import prices up by around one quarter of a point. With the pound now trading below 101p against sterling, that is a 3 per cent devaluation over the past couple of months.

As the ESRI and others have pointed out, it is our high exchange rate against sterling which has been a key factor in keeping the lid on inflation. This week the pound has also started to fall on a tradeweighted basis. The trade weighted index is still well above last year's level - helping to explain why inflation has been so subdued but the bank will want to see this maintained to keep import prices down. On top of that, there are inflationary pressures in the pipeline from rising oil prices and more expensive car insurance.

Against this backdrop, what has the bank been up to? Most observers now assume it has been trying to keep the pound within the 2.25 per cent margins of the old, now abandoned, ERM band.

The Maastricht Treaty requires that currencies must have a stable trading record before entry to a single currency, although there are no specific rules laid down. The pound has been one of the more volatile of the likely entrants.

Added to that is the political problem surrounding the farmers. From the EU ministers' meeting in Killarney, when the farmers rioted over BSE cuts, to the "Ivan the Terrible" headlines of recent days, the authorities have been under pressure from the agricultural lobby. A further cut to farming incomes because of a green pound revaluation is not something that would he welcomed.

Partly to avoid such a revaluation, which would he triggered if the pound remained strong against other EU currencies, the Central Bank has recently been selling pounds, driving us down further against a strengthening sterling. But this selling adds liquidity to the Dublin money markets and could lead to pressure for lower interest rates, which is the last thing the bank wants.

So what are the options open to try to rein in the economy? One option would be to tighten fiscal policy. With a tax cutting Budget certainly on the agenda for next year, this is ruled out.

It looks as if the time has come for the Central Bank to swallow the pill and take the other option by allowing the exchange rate to rise. Its choice is clear a volatile exchange rate against the D mark, which is not strictly ruled out in Maastricht, or the risk of higher inflation, which could endanger Ireland's qualification.

For the moment, the bank may hope that sterling will slip back and the D mark recover, easing its current dilemma. But if this does not happen soon, it will have to nail its colours to the mast.